Capitalization and the Cost of Goods Sold

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Last year, the Internal Revenue Service issued an advisory from its Chief Counsel’s office to answer a question related to allocating the cost of goods sold (COGS) that includes post-production costs. The IRS concluded that because the costs are properly capitalized to current year production, they must be included when determining COGS. Here is the legal argument behind the IRS decision.

First, the case facts: X Corporation manufactured product A from 1996 through 2004, and manufactured the next generation of product A – called product B — from 2005 through 2008. An employee named Mr. Blue was involved in the company’s production process until he retired in 2000. In 2008, XCorp paid $30 of Mr. Blue’s medical expenses based on an existing medical plan for retired employees. These costs were subject to capitalization under Section 263A of the Internal Revenue Code. (Section 263A provides that taxpayers must capitalize their direct costs and a “properly allocable share” of their indirect costs to inventory.)

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A second employee, Ms. Red, had been involved in XCorp’s production process her entire career and was injured in 2004 while manufacturing product A. In 2008, XCorp paid Ms. Red $20 of worker’s compensation payments for her injuries sustained in 2004. These costs were also subject to capitalization under Section 263A.

From 2000 through 2004, XCorp’s production activities discharged hazardous waste at the factory. As a result, in 2008, the company incurred $400 in environmental remediation costs. Again, these costs were also subject to capitalization under the same tax rule, Section 263A.

Allocating Costs

Under the Code’s Section 199, the IRS allows a deduction equal to a specified percentage (the currently applicable percentage is 6%) of income attributable to domestic production activities. Section 199 is effective for taxable years beginning after December 31, 2004. The deduction is limited to a percentage of the lesser of: (1) “qualified production activities income” (QPAI), or (2) taxable income. QPAI is the excess of domestic production gross receipts (DPGR) over the COGS allocable to such receipts, as well as other expenses, losses, and deductions allocable to such receipts.

According to tax regulations – specifically Regulation Section 1.199-4(b)(2)(ii) – the rules say that if a taxpayer recognizes and reports gross receipts on a federal income tax return for a taxable year, and incurs COGS related to such gross receipts in a subsequent year, then the taxpayer must allocate the COGS to non-DPGR. Indeed, this is the case if the taxpayer recognized the gross receipts (to which the COGS is related) in a taxable year to which Section 199 did not apply. What’s more, the allocation essentially means that the QPAI will be increased

As a result, the issue brought before the IRS was whether the “2008 expenses” were properly allocable to gross receipts of the current year or of a prior year. The IRS concluded in the Chief Counsel’s memo that the expenses were properly allocable to a prior year. (See LTR 200946037, October 26, 2009.)

The ruling concluded that because Section 263A and the associated regulations require the 2008 expenses to be capitalized to property produced in the current year — and because the treatment of Section 199 expenses are generally required to conform to the treatment of Section 263A costs — the 2008 expenses must be included in determining COGS allocable to DPGR. Note that the regulations state that employee benefit costs, including worker’s compensation, are indirect costs required to be capitalized. Further, Revenue Ruling 2005-42, 2005-2, C.B. 67, holds that environmental remediation costs are incurred by reason of production activities.

Therefore, since under Section 263A the costs are properly allocable to inventory produced during the taxable year, the costs are “incurred.” In this case, a liability is incurred only in the taxable year in which “all events” have occurred which establish: the fact of the liability; the amount that can be determined with reasonable accuracy; and that theeconomic performance has occurred.

The IRS observed that the 2008 expenses are not related to gross receipts received in a prior year. Instead, those expenses are included in the inventory cost of property produced in the current year and, thus, are “related to” the gross receipts generated from the sale of those goods. In short, inventory costs incurred in the current year are allocated to property produced in the current year. and the treatment of Section 199 expenses are generally required to conform to the treatment of Section 263A costs.

The IRS went on to note that the “theme” of Regulation Section 1.199-4(b)(2), upon which CorpX mistakenly relied, is that the cost of property should be allocated to the type of receipts that the sale of the property generated. In the view of the IRS, the cited regulation applies in very limited circumstances, such as when a taxpayer receives an advance payment or uses the cash receipts and disbursements method of accounting — none of which were applicable to CorpX.

As a result, because the 2008 expenses were subject to capitalization under Section 263A, they are allocable to property produced in the current year. That means in the case written about in the Chief Counsel’s memo, the expenses were properly allocated to DPGR to arrive at QPAI.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.